Embracing Change: Why Netflix Keeps Winning

In the battle for market share, the concepts that separate the winners and losers are quite simple. The winners give their customers more bang for the buck and bargain with suppliers to deliver that bang at a cost below their price so they can make a profit. The losers get stuck trying to defend their old approach to doing business. This difference helps explain why Netflix's (NFLX) stock has nearly quadrupled so far in 2010.

Netflix's shift from focusing on DVD rentals to online video streaming is a great demonstration of a company applying these winning concepts. In the mail-order DVD business, the possibility of increasing postal charged posed an obvious risk. Instead of simply planning to compensate with higher prices, the company turned the higher postage charges into an impetus for change.

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Netflix already had grown a large customer base for its service, which supplies unlimited DVD rentals by mail for a single monthly fee, with no late charges. Members with a one-DVD plan, for example, get the next DVD on their list whenever they mail the last one back; subscribers with two-DVD plans can have two discs out at a time, and so on. But Netflix was concerned that its customers would not want to foot their share of the growing postal bill, which it expected would grow from $600 million to $700 million annually over the next few years, Vice President of Communications Steve Swasey told me back in March.

It paved the way for a switch by offering streaming downloads to its subscribers. Then on Monday, it introduced a new service plan that gives customers unlimited monthly downloads for $7.99 a month, a lower price than its previously lowest-priced service, an $8.99 plan (which now costs $9.99) that gives customers one mail-order DVD at a time, along with unlimited downloads.

Will Buyers Snap up the Bargain?

It remains to be seen whether the new plan will attract more subscribers than its $19.99-a-month plan. I'd bet that consumers will switch to the download-only service only if it delivers all the video titles they want at the new, lower fee. But if enough customers do switch, Netflix revenue will likely drop.

Still, Netflix can afford to offer this lower-priced streaming service because it was able to catch content suppliers in a moment of weakness. A few months ago, Netflix paid Paramount, MGM and Lionsgate almost $1 billion to stream their movies. That sounds like big bucks, but actually represents small change per film compared to a few years ago, when studios sold DVDs for $30 each.

Thanks to competition from cable companies, which offer on-demand video and other online streaming sources, DVD prices have plummeted. And, unfortunately for Hollywood studies, the streaming content deals are nowhere near as lucrative as previous DVD ones. Netflix was able to get a much lower price than what cable and satellite owners pay. For example, the company pays 15 cents a month, per subscriber, to stream movies from Sony (SNE) and Disney (DIS) through pay-TV channel Starz. That's only about 3% of the $4 to $5 per month that cable and satellite owners pay for access to the channel, says Rich Greenfield, an analyst at BTIG Research.

Competitors Bite the Dust

Moreover, Netflix is transitioning from a DVD renter to an online streamer even as competitors, like Blockbuster (which went bankrupt in September), remained too focused on their owners' needs to adapt. As I posted on DailyFinance in September 2010, Blockbuster struggled with cash flow after Viacom's (VIA.B) disappointing August 1999 public offering, but its deeper problem was that it was consistently late to the new-technology party.

Netlix did not suffer from that problem. With its 16 million customers accounting for 20% of all North American evening download traffic, according to broadband equipment maker Sandvine, Netflix has significant bargaining power with these suppliers. Of course, it's too early to call the switch to online streaming a success.

Content providers are fighting back. Studios are delaying release dates, forcing Netflix to wait 28 days while studios sell more expensive and lucrative DVD and on-demand versions on cable. And some of the studios, like Time Warner (TWX), are starting their own online streaming services.

Who will win? Whichever competitor offers consumers the most compelling service at the best price. And given its success in outpacing competitors so far, I would hesitate to bet against Netflix.